Saturday, November 29, 2008

Arbitrage is the practice of taking advantage of a price differentials. Buffett has typically practiced risk arbitrage. With risk arbitrage, a stock price trades in the market at a discount to some future value. In particular, he has looked to invest in large merger transactions where the merger has been publicly announced and is considered to be a friendly event.

Buffett counsels that investors should answer four questions in order to evaluate a risk arbitrage situation:

1) How likely is it that the announced event will take place?2) How long will your money be tied up?3) What is the chance that something better will transpire (e.g. a competing bid)4) What will happen if the event does not take place?

Buffett has practiced arbitrage for decades and estimates that Berkshire has earned on average a 25% pre-tax return on arbitrage operations. He sees risk arbitrage as an alternative to investing in short term treasuries.

Around 1989, Buffett started to withdraw from arbitrage transactions. He noticed that with the increasing popularity of leveraged buyouts came an environment of "unbridled enthusiasm" caused by financial excesses. Buffett has always acted fearful when others were greedy and this may be why he has increasingly looked to make deals with convertible preferred deals rather than arbitrage.